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  • Dec 24, 2009 - Understanding Profit & Loss Statement of Banks and Financial Institutions

Understanding Profit & Loss Statement of Banks and Financial Institutions

Dec 24, 2009

In the previous article of this series, we discussed some of the key ratios relating to the cash flow statement. With that, we concluded our discussion on financial statements.

But we have till now discussed the financial statement only for non-financial companies which include firms involved in manufacturing and providing services.

On the other hand, financial statements of financial firms such as banks are very different.

In the next few articles, we will talk about the financial statements for banking and financial institutions.

As per banking regulations, banks' accounts are presented in a different manner. As such, one needs to analyze the same in a different manner.

Before we get into a detailed discussion, we think it would be better to start right at the basics.

For this, we will see the difference between the financial statements of a financial organisation and a non-financial organisation.

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Profit and Loss Account: Manufacturing Company vs Banks

Let's start with the profit and loss account.

A non-financial company, say a manufacturing company, derives revenues from product sales.

The expenses for the company would include that of raw materials, labour, power and fuel, salaries and wages, administrative costs, among others.

For a bank, this is quite different.

The basic function of a bank is to accept deposits and give out loans. On the loans that it gives out, it charges an interest rate.

This interest earned is the key revenue source for a bank. This term is known as 'interest income'.

Apart from interest income from loans advanced, it also earns interest from certain investments that it makes.

In addition, a bank is also required to keep a certain amount of its cash reserves with the Reserve Bank of India (RBI).

However, it must be noted that a bank's interest income from investments depends upon some key factors like monetary policies (cash reserve ratio and statutory ratio limits) and credit demand.

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Cash Reserve Ratio and Statutory Liquidity Ratio

Cash reserve ratio (CRR) is a certain percentage of deposits which a bank is mandated to maintain with the RBI.

Statutory liquidity ratio (SLR) is the second part of regulatory requirement, which requires banks to invest in G-Secs (government securities).

The bank's revenues are basically derived from the interest it earns from the loans it gives out as well as from the fixed income investments it makes. If credit demand is lower, the bank increases the quantum of investments.

Apart from interest income being the key revenue source for a bank, it also earns income in the form of fees that it charges for the various services it provides.

These services include processing fees for loans and forex transactions, among others. It's believed that banks derive nearly 50% of revenues from this stream in developed economies.

In India, the story is very different. This stream of revenues contributes about 15% to the overall revenues.

Expenditures of Bank and Financial Institutions

Now that we have covered the income part of the profit and loss account, we shall move on to the expenditure aspect of the same.

The key expense of a bank is interest on deposits that are made with it. These could be in the form of term (fixed) or savings bank account deposits.

The second biggest expense head for a bank would be its operating expenses. This head would include all operational costs, which even non-financial companies expend.

Some of these include employee costs, advertisement and publicity costs, administrative costs, rent, lighting, and stationary.

Under expenses, there is also an item included called 'provisions and contingencies'. In the simplest terms, these are liabilities that are of uncertain timing or amount and includes provisions for unrecoverable assets.

In accounting terms, such provisions are called as 'Provisions for non-performing assets (NPAs)'. Apart from NPAs, these provisions also include provision for tax and depreciation in the value of investments.

After removing these heads from the income generated, we simply arrive at the profit figure. The process of appropriation thereafter is similar to that of non-financial companies.

We shall take up an example to understand this.

Displayed below is the profit and loss account of HDFC Bank.

Data Source: HDFC Bank Annual Reports

The total income generated by the bank during FY09 was Rs 198 bn. Of this, interest income was Rs 163 bn. The balance was contributed by other income.

Out of the Rs 163 bn of interest income, HDFC Bank earned about Rs 121 bn from interest on loans advanced/bills.

The income from investments during the year stood at Rs 40 bn, while interest from the balance with RBI and other inter-bank funds stood at Rs 2 bn.

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During FY09, HDFC Bank earned revenues of Rs 34 bn as other income. The largest contributor here was fee income (commission, exchange, and brokerage) to the tune of Rs 26 bn. This translates as 13% of the total income during the year.

Other major contributors were profit on sale of investments and exchange transactions.

Now moving on to the bank's expense account. The total interest expended stood at Rs 89 bn.

The interest on deposits stood at Rs 80 bn, while interest on borrowings from other sources such as the RBI and other bank borrowings stood at Rs 6 bn.

Operating expenses during the year stood at Rs 56 bn. The major contributor to this head was employee costs (Rs 23 bn). Provision and contingencies amount stood at Rs 29 bn.

Key Ratios for Banks' Profit and Loss Statement

As a bank's accounts are very different from that of a manufacturing firm, it would be necessary for an investor to understand some of the key performance ratios.

As you must be aware, analysis of a bank's accounts differs significantly from any other company due to their structure and operating systems.

Those key operating and financial ratios, which one would normally evaluate before investing in company, may not hold true for a bank.

The three important key ratios associated with a bank's profit and loss statement are.

  • Net interest margin (NIM)
  • Operating profit margin (OPM)
  • Cost to income ratio

Let us understand each of these in detail...

Net Interest Margin (NIM): Just as we calculate and measure performances of non-financial companies on the basis of their operating performance (EBITDA margins), the performance of banks is largely dependent on the NIM for the year.

The difference between interest income and interest expense is known as net interest income. It is the income, which the bank earns from its core business of lending.

As such, NIM is the net interest income earned by the bank on its average earning assets. These assets comprise of advances, investments, balance with the RBI and money at call.

It's calculated as follows.

NIM = (Interest Income - Interest Expenses) / Average Earnings Assets

Operating Profit Margin (OPM): A bank's operating profit is calculated after deducting operating expenses from the net interest income.

Operating expenses for a bank would mainly be more of administrative expenses. The main expense heads would include salaries, marketing and advertising and rent, among others.

Operating margins are profits earned by the bank on its total interest income.

OPM = (Net Interest Income (NII) - Operating Expenses) / Total Interest Income

Cost to Income Ratio: Be it a bank or a manufacturing firm, controlling overheads costs is a critical part of any organisation. In case of banks, keeping a close watch on overheads would enable it to enhance its return on equity.

Salaries, branch rationalisation and technology upgradation account for a major part of operating expenses for new generation banks.

Even though these expenses result in higher cost to income ratio, in long term they help the bank in improving its return on equity.

The ratio is calculated as a proportion of operating profit including non-interest income (fee based income).

Cost to Income Ratio = Operating Expenses / (NII + Non-Interest Income)

PSU Banks Versus Private Banks

Since we're talking about banks, it would be helpful to understand the differences between a public sector bank (PSU) and a private bank.

It is also a never-ending debate in the Indian stock market. PSU banks or private banks and which ones should one favour?

In the video below, Brijesh Bhatia shares his view on the topic and makes a case for PSU banks and why they still have a long way to go.

Tune in to the video below to know more.

Here Are Links to Some Very Insightful Equitymaster Articles on Banks and the Banking Sector

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5 Responses to "Understanding Profit & Loss Statement of Banks and Financial Institutions"


Jan 23, 2018

nice overview.



Jan 1, 2010

Articles Useful and thought provoking.Please mail all the Articles from archieves to my mail.

Like (2)


Dec 30, 2009

The last line of the article has the link to the previous articles.

Like (2)

Turab Dedanwal

Dec 29, 2009

Dear Sir
I am the new memeber of the Equity Master and would like to have all the previous issues of "Investing - Back to Basics". If possible the issues can be mailed to me at the above address

Like (1)


Dec 25, 2009

As a C.A I find these articles very interesting , I would like to have the editions
Investing : Back to basics I - X.Please let me have these

Like (2)
Equitymaster requests your view! Post a comment on "Understanding Profit & Loss Statement of Banks and Financial Institutions". Click here!

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